GDP and Measuring the Intangible

GDP statistics lead us to take an overly pessimistic view of the economy. There is no Great Stagnation. There is only a widening gap between the rate of economic improvement and our ability to measure that improvement.

Diane Coyle’s new book, GDP: A Brief But Affectionate History, is a timely contribution to discussions of modern economic performance. She argues that Gross Domestic Product increasingly underestimates well-being, and therefore reports of our economy’s stagnation may be greatly exaggerated:

It is above all important not to confuse GDP with social welfare. The way the economy has changed has made the gap between GDP and welfare bigger than it used to be. The acceleration in the variety of products, in customization, and in the blurring of the boundary between leisure and work in many creative professions and vocations — all of these mean that GDP growth increasingly underestimates increases in welfare. Contrary to the popular impression that it exaggerates the improvement in our standard of living, the opposite may be true.

Coyle points out that GDP was implemented first in the United States and the United Kingdom in the 1930s, at a time when these economies were dominated by production of tangible goods. When war loomed on the horizon, the original goal of designing GDP to measure social welfare was abandoned. Instead, government leaders were focused on assessing their societies’ ability to carry on a military conflict. GDP became a measure of the economy’s production of guns and butter.

GDP is focused on goods and services that are traded for money in market transactions. It omits the informal or underground economy, and it does not count work when no money is involved. As Coyle puts it, when a widower marries his housekeeper, GDP goes down, because the housekeeper no longer is paid for the work that she presumably continues to do.

I believe that consumer surplus may be a multiple of measured GDP. I believe that we value indoor plumbing by much more than it costs.

From the standpoint of measuring social welfare, the most important omission in the GDP statistics may be what economists call consumer surplus. Consumer surplus is defined as the additional value of a good beyond what can be measured in its cost. A flight to Miami from Boston or Philadelphia costs much less than the value that travelers get from it — especially in a winter like the one we have experienced this year!

As Coyle points out, discussions of the value of the Internet inevitably come around to the issue of consumer surplus. Because typically what you can find on the Internet is free, its value cannot be captured by measuring how much you pay for it. All of the value of this zero-cost entertainment and information is consumer surplus.

In fact, I believe that consumer surplus may be a multiple of measured GDP. I believe that we value indoor plumbing by much more than it costs. The same is true for washing machines (see Hans Rosling’s video, and note that the video itself is available for free), televisions, microwave ovens — in fact, just about every appliance that uses electricity.

Or consider health care. When medical procedures and drugs alleviate pain or cure illness, the value to us is much higher than what it costs. As economists Kevin Murphy and Robert Topel put it:

Cumulative gains in life expectancy after 1900 were worth over $1.2 million to the representative American in 2000, whereas post-1970 gains added about $3.2 trillion per year to national wealth, equal to about half of GDP.

Even though Americans probably spend a great deal on medical procedures that have relatively low benefits, the overall consumer surplus from health care is enormous and is not included in GDP.

‘The economy is not primarily a physical but rather an intangible entity now.’

Coyle writes that “the economy is not primarily a physical but rather an intangible entity now.” GDP statistics were first implemented in the context of an economy that produced physically measurable goods, such as tons of steel or bushels of wheat. For industries that provide intangible output, such as education, finance, insurance, or regulatory protection, quantitative measures are less meaningful.

As Coyle points out, an increase in the variety of goods also produces gains in welfare that are not included in GDP. Again, think about this from the standpoint of consumer surplus. If you and I go to a food court with many restaurants, then I will choose the meal that gives me the most consumer surplus, and you will choose the meal that gives you the most consumer surplus. Each of us will get more consumer surplus than if we had been forced to get food from the same restaurant.

Overall, one arrives at a mixed verdict on GDP. On the one hand, it is the best way that we have to measure economic capability. On the other hand, because it fails to account for consumer surplus, GDP statistics lead us to take an overly pessimistic view of the economy. There is no Great Stagnation. There is only a widening gap between the rate of economic improvement and our ability to measure that improvement.

Arnold Kling is a member of the Mercatus Center’s Financial Markets Working Group at George Mason University.